Tuesday, 23 July 2013

China brings out the big guns

Staying in control of
a rampant economy is not easy but the Chinese government shows that it has the
necessary firepower.

While investors follow the movements of central banks with
one eye, their other eye would most likely be following the fortunes of China. The rapid rate of expansion in the Chinese
economy seen over the past couple of decades may be coming to an end with the
era of cheap labour seemingly coming to an end.
But the centralized government in China has so far shown itself apt at
managing the Chinese economy through its growing pains (see Why China need a slowdown? for related story). Despite mounting concerns over
economic growth in China, Your Neighbourhood Economist believes that the
Chinese government has both the necessary firepower to point the economy in the
right direction and the willingness to use it.

In its current state of development, the economy in China is
still very much like the Wild West – lots of small firms battling it out in a gun
fight to see who comes out on top. This
analogy does not hold so well when taking in consideration the giant state-owned
companies which dominate parts of the economy or firms such as Huawei or Baidu
who have already grown to the point where they are mostly above the fray. But
China is a world away from having a few large firms dominate each industry as
would be the case in most Western countries. As such, competition is fiercer with big
rewards awaiting those that can prosper.
The Wild West analogy also reflects the relative state of lawlessness in
China where firms don’t have to worry as much about issues such as pollution,
labour standards, and respect of intellectual property.

To add to the lawlessness, politics in China can seem at
times as it is run by a bunch of gunslingers.
The higher levels of government are choreographed pieces of political
theatre but politics at lower levels is more of a grubby battle. Ambitious officials in regional government in
China need to impress in terms of economic growth or social stability and can often
become a law unto themselves whether it be taking land from farmers to build
factories or getting local banks to splash out on loans to businesses. This
incentive to create booming local economies can act against central government diktats
even though both levels of government are controlled by the communist party.

Banks themselves have also managed to avoid the rule of law
and operate with a degree of impunity.
The government sets maximum rates for savers and minimum rates for
borrowers with a big gap inbetween to help banks generate a profit. This suits the major banks which are government
owned but savers miss out due to meagre returns on any cash stashed away. But banks keen to attract more deposits have
come up with schemes to offer higher pay outs for investors and this extra cash
has enabled the banks to lend even more.

The relative autonomy of local politicians and banks in
China has fuelled a lending binge that has gone a bit out of control. The ratio of debt to GDP has reached 200%
which is well past the point when people start worrying. The leaders in China have tried a softer
approach such as signalling their disapproval but to little effect. But the Chinese government has never shied
away from stepping on toes and decided to bring out some big guns to put pay to
the wayward banks. At a time of year
when all of the scheming by banks had left them short of cash, the central bank
in China left banks to sort the cash shortfall out themselves despite typically
acting as a source of funds in the past. The lack of money resulted in banks
scrambling for cash and interest rates surged upward briefly topping 25% in the
middle of June (search for SHIBOR spike for more info). This created turmoil among Chinese banks, for
whom not only were the central bank’s actions a complete surprise but the
intentions behind the move were also a mystery.

Some interpreted the actions of the central bank to be a
brutal way of knocking banks into line but it will probably prove to be more
fruitful than the policies of the their Western counterparts. Whereas other central banks have struggled to
maintain stability (see Why is the economy still stuck in a rut? for more on the limited influence of monetary policy elsewhere), China’s
central bank is not afraid of drastic action to shake things up even if it will
result in a bit of temporary chaos. The
spike in interest rates is expected to have put many banks into trouble but
will be good for the banking system as a whole if it helps to reign in
lending. Officials in China are
conscious of the need to keep the economy growing so that the Communist Party
can maintain its grip on power. It is
this focus on the big picture rather than the fickle concerns of voters that
will keep the Communists in power in what is destined to soon be the world’s
largest capitalist economy.

2 comments:

Am intrigued by the headline. The current policy of the Chinese government is not to deploy its economic firepower. It did that in 2009-10, with a bigger stimulus than in the US. It is now living with the consequences chief of which is the debt bubble.

You argue the banks are independent of the central government (and this allowed profligacy) but the reverse is true - it is precisely because of the government's iron grip of the banking sector that it was so profligate - the large banks are used by the government as tools to finance deployment of capital to politically useful projects and to allow them to recover slim profits from all this activity by allowing them a fixed margin which gives no incentive to lend for profit to genuine risky and profitable borrowers which could result in authentic economic growth.

In 2009 the NDRC handed out documents directing banks lend to big infrastructure projects at a rapid rate (recently there was a story about the NDRC funding a project to manipulate the weather). One could go on with more examples of the closeness between government and banks.

When you consider the structure of the bond market means there are no meaningful interest rates and no pricing of risk at all the only conclusion is that the entire system is a ponzi scheme.

Yes the numbers are large and in size appears strength. And it is true the banks have dived in to shadow banking activities as revenues have been squeezed. The banks are drowning in seas of defaulting portfolios which are currently off-balance sheet and may in fact be technically insolvent.

You say that China's leaders are acting and in control. Others make an argument that the opposite is the case - it is always hard to tell if those in authority are being proactive or reactive. But the key point is that China is an open system now and there is a limited room for manoeuvre - at some point questions as to the bad data will be significant that many investors radically revise their views on China.

Your Neighbourhood Economist would still argue that banks are independent of the government in China - otherwise how do you explain the shadow banking activities in the finance sector which are not sanctioned by the Communist party. The one party state gives off the illusion of centralised power but there are many different sources of power with their own agendas - this became a little more obvious with the fall from grace of Bo Xilai in 2012. Banks have some leeway in how they act with regard to government edicts which is one reason why the growth of credit has gotten so out of hand and why the government had to put an end to it through the slapdash method which resulted in the Shibor spike.

China does not yet need a finance sector to redistribute funds around the economy as the economy is still in the earlier phases of development but the banking sector will become more important in the next few years as China looks for domestic sources of growth rather than relying on exports. To this end, the government is in the process of reforming the banking sector such as the removal of the floor on interest rates for lending. The pundits fear the worse as it is difficult to understand the workings of politics in China as it is all carried out behind closed doors. But Your Neighbourhood Economist has faith in the Chinese government. Further development in the economy will make it more difficult to control but it is the necks of the Communist party that are on the line - what more motivation to you need than that.